Relative Strength Investing Basics: Seeking Better-Performing Stocks - dummies

Relative Strength Investing Basics: Seeking Better-Performing Stocks

By Greg Schnell, Lita Epstein

Relative strength investing looks for stocks with better price movement so an investor can outperform the market. The idea behind relative strength investing is to find stocks that are outperforming the other stocks so you actually outperform the market. If the S&P 500 is up 10 percent in a year, for example, you want to use relative strength investing strategies to outperform the index. Otherwise, you can just buy the index, and that will get you diversification into various sectors.

The following information provides some fundamentals on relative strength investing: how sectors and industries come into play, what constitutes a strong stock, and what to check on your charts when you use this investing strategy.

The word strength in the stock market refers to stocks that have strong price action in the up direction. When you think about a rising market, if all the stocks seem to go up, what is the issue? Well, in a rising market, an investor can just buy the SPY exchange-traded fund (ETF) or the QQQ ETF to get a basket of some of the biggest stocks out there. This would be passive investing.

Sectors and industries

The market is broken down into sectors and industries. When whole sectors or industry groups are doing well, that can be a great clue to finding new stocks. The methodology for creating these industry groups is not specific to each stock market. These sector components may be on the New York Stock Exchange (NYSE) or the NASDAQ.

Here, the market has 11 sectors and 157 sub-industry classifications. These are based on the Global Industry Classification System (GICS). The image below highlights industries within the energy sector.

stock charts sectors and industries
Sectors and industries.

When you’re trying to pick stocks, your first task is to determine whether an entire sector is moving up or just a particular industry in that sector. For example, you can pick any energy company, or you may want to focus your investing in integrated energy. After you decide, you can look for the strongest stocks in the sector or industry.

What makes a strong stock

The difficulty with the concept of investing in strength is that everyone will tell you to buy strong stocks. Defining a strong stock may be different for every stock market investor, however.

Accountants will probably default to companies with good earnings and good growth, but Tesla stock (as just one example) has doubled in under a year with losses year after year. Amazon’s stock continues to rise and is around $1,000 a share, but it spends all of its profits year after year on growing the business, and the shareholders continue to look at a company with terrible bottom-line profitability because of the reinvestment. Yet the Amazon stock price action is great.

Pipeline companies have huge, consistent earnings, and the stocks are flat to down on the year. Grocery companies deliver cash flow every month, but the stock price increases are lackluster. If you look at high-margin retail stocks like Coach and Michael Kors, they have been out of favor as Amazon puts pressure on retail store strategies. They may cycle back into the fastest-growing theme.

Industrial companies do well with a receding U.S. dollar. Commodity companies have been poor performers from 2011 to 2016, but they have years where they are the top performers. Technology companies have been soaring for years. Biotech companies were soaring, went out of favor for two years, and then started 2017 soaring higher. It seems so confusing.

What can cause this shift, and more importantly, how can you stay on top of it? Opinions don’t help find strong stocks. You need to see institutional-size investors pushing the stock price higher at a rate that is faster than other stocks and faster than the broad index of good companies. (After you own the stocks, how do you know when to sell? There is never an obvious signpost saying “Exit now.”) Going back to the definition: Relative strength investing looks for stocks with better price movement so an investor can outperform the market. Chartists are continually on the watch for the fastest-moving charts in the market.

4 things to know in relative strength investing

For relative strength investing based on charts, you want to know four things in real-time:

  • When the stock starts outperforming (for example, new three-month highs)
  • When the stock starts rising faster than most stocks
  • When the stock starts underperforming other stocks
  • When to leave the stock

Trying to invest in top-performing stocks and accomplish great investing goals is the result of lifelong learning for investment managers. Relative strength tools enable you to find them as well.